The market has responded positively as forecasts for additional increases in US rates seem to have been premature. After expectations that the UK would follow a similar gradual rate hiking path to the US, it has experienced a drastic change in sentiment.
Following the vote for Brexit, market participants have not only removed the probability of a rate hike in the near future but there is now much speculation about an increased probability of a rate cut.
This provides further support to an already strongly performing gilt market and further depresses an already beaten-down British pound, which has fallen to levels not seen since the 1980s after a 10% overnight devaluation against the USD on the back of the referendum result.
Tactical adjustment
Although most managers did not anticipate a vote in favour of leaving the EU, the majority of them still adjusted portfolio risk marginally in case of a sell-off. The most notable protective strategy was to be long US treasuries given its safe-haven status and the more attractive yields on offer relative to other developed market sovereign bonds.
As at mid-June, the US 10-year treasury yield was 1.6%, versus 1.14% for 10-year UK gilts, 0% for 10-year German bunds and 10-year Japanese government bonds at -0.15%.
This was especially relevant for man-agers with GBP or EUR-based portfolios. Additionally, some managers chose to gain exposure to UK inflation-linked bonds, expecting a victory for Brexit to drive the value of GBP down versus other major currencies, in turn putting upward pressure on inflation expectations.
Following the referendum result, global fixed income managers have not made any material changes to portfolio positioning. If anything, the ensuing sell-off in risk assets, which had a small negative impact on corporate credit, would have been an opportunity for security selection, with little implication on macro positioning given the uncertain future for the UK’s relationship with the eurozone.
The Brexit-induced sell-off at the end of June was more punishing for financials, and within the sector equities dropped more drastically than bonds.
Looking ahead, given the record low levels of government bond yields, global fixed income managers with the ability to dabble in credit markets will continue to look for opportunities in spread sectors. Accommodative developed market central bank policy will continue to suppress yields, compressing spreads further – a scenario for which managers have been positioned for the past couple of years and look set to remain so.
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